Examining fraudulent accounting and auditing practices

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Recent international corporate collapses did not happen in a vacuum. Fraudulent accounting and auditing practices, amongst others, were a contributing factor towards these collapses. Motivations for material advantages and pursuits of self-interest are shown by economic and political agendas, the growth in compensation for executives and the apparent declining ethical standards among company directors and auditors (Dellaportas, et. al, 2005). The extent of management greed, the failure of boards to exercise good corporate governance practices such as remuneration payouts, and the record level fees and commissions earned by analysts and accountants on advisory services are also grieved by Knott, 2002.

Against a background of high profile corporate collapses in the early 2000's, including the demise of Arthur Andersen following the Enron collapse, the credibility of financial reporting has been seriously questioned, and the roles of auditors and accountants have been subject to scrutiny. Arthur Andersen was the auditor for both Enron and WorldCom, the two companies responsible for two of the biggest cases of accounting fraud in American history. These challenges, however, have been met with legal reforms and a range of other initiatives within the profession itself.

The collapse of entities such as Enron, HIH and WorldCom have moved regulatory reforms higher up the public agenda, particularly as they relate to disclosure and audit. This has seen the enactment of many codes and regulations such as the Sarbanes Oxley Act (2002) in the United States, the Corporate Law Economic Reform Program (CLERP 9) in Australia. The Enron and WorldCom collapses are examples of misleading financial reporting and lack of audit integrity and independence.

The Sarbanes Oxley Act 2002 evolved following a series of high profile corporate collapses in the United States. The goal of the Act was to protect investors by improving the accuracy and reliability of corporate disclosures (Dellaportas, et. al, 2005).

This assignment seeks to discuss the financial regulation issues posed by the WorldCom and Enron scandals, leading ultimately to their collapse. An attempt is made to determine the extent to which the Sarbanes-Oxley Act will be able to remedy the deficiencies in the financial regulations and the accounting and auditing practices, and thus avoid such future collapses as Enron and WorldCom.


Enron was founded in 1985 by chairman Kenneth Lay as a natural gas pipeline company. Enron had adopted the use of mark-to-market accounting, recognizing the full value of future deals on current market prices, which made the company appear more profitable than it really was. As the internal auditors and the Arthur Andersen external auditors tolerated the increasingly aggressive accounting methods of Enron, CEO Jeffrey Skilling entered the more hazardous broadband market (CPA, 2009). Enron's resulting financial problems set the scene for CFO Andrew Fastow's creation of a complex web of special purpose entities (SPE's) (CPA, 2009). SPE's are common in the United States [1] . As they were off-balance sheet, SPE's could allow the core business to expand without incurring increasing debt. Enron used the 3% rule in creating these illegal SPE's, which states that 3% of a subsidiary's startup capital must be from an outside investor (Buondonno, et. al., 2005). Enron essentially received this outside investment from managers in Enron or their wives. The accounting firm, Arthur Anderson, had demonstrated the consequences of auditor capture. (Arthur Anderson received US$100 million per annum from Enron in auditing and consulting fees). In approving the SPE's, tolerating Fastow's conflicts of interest and giving credibility to Enron's aggressive accounting methods of dubious legality, Anderson had placed its own future in jeopardy (CPA, 2009). In the event, the accounting firm collapsed before Enron. The direct result of Enron was the rapid passage of the SOX in 2002 which addresses conflict of interest in the auditing profession.

Enron's public image before October 2001, depicted by its healthy stock market price, was quite contrary to its economic reality. It was a company with high growth rates, with analysts highly recommending its shares. Enron had developed a corporate culture that emphasized innovation, recruiting the best and brightest, healthy competition among staff, aggressive approaches to deal making, and novel and unique contract offerings (CPA, 2009). However, behind this success was the reality, taking the form of hidden manipulations and accounting fraud. Off-balance sheet accounting, capture of fair value and employment of creative accounting practices on the income statement were some of the policies employed by Enron. "Its policy essentially consisted of transferring the most devalued assets, a priori unmarketable to companies which appeared at first glance to be autonomous, but which were in fact controlled by Enron. Heavy use of off-balance sheet accounting and deconsolidations, allowing Enron to undervalue its debt and to dispose of troublesome assets, became the company's trademark" (Aglietta & Reberioux, 2005). Abuse of the fair value principle was also rife. Declaring fabricated capital gains by passing off depreciated assets onto affiliates at subjectively fixed prices was yet another practice embarked onto by Enron. A classic example is the recognition of $67 million profit on the sale of an asset to LJM2 for $100 million, whose internal valuation was $33 million. The notion of fair value was used when market prices increased, but neglecting the reduced balance sheet values when market prices declined. An internal document of July 2001 thus recognized a $2.3 billion overvaluation of international assets resulting from this unconventional use of fair value (Aglietta & Reberioux, 2005). Creative accounting techniques were also used, taking the form of revenue overstatement (particularly through exchange of goods with SPE's) and expense understatement (through delaying depreciation of assets and underfunding risks).


WorldCom was one of the biggest telecommunication companies in the United States. Initially operating as Long Distance Discount Services, it was renamed WorldCom in 1995. Founded in 1983, the company grew quite remarkably through aggressive leadership and acquisition of several companies. However, it was not through honest means that the company brought about its growth. Eventually, as a result of fraudulent accounting procedures depicting false profitability and financial growth image, the company filed for bankruptcy on July 21, 2002.

Its collapse through manipulating accounts to show inflated profits had put questions on corporate accountability and of the greediness of directors. The SEC alleged that WorldCom's top management "disguised its true operating performance" and "misled investors about its reported earnings" (Sridhar, 2002). The company tried to boost revenues and profits while hiding expenses. Sridhar, 2002 further states that "by classifying ordinary day-to-day expenses as investments and long-term expenses associated with the acquisition of capital assets, on which companies enjoy certain tax advantages, WorldCom was able to hide expenses to the tune of nearly $4 billion and instead show this as profits". One of the major operating expenses that WorldCom capitalized as investments was its 'line costs [2] '. This was clearly a violation of the accounting rules as the line costs was a day-to-day expense, and should have rightfully been expensed. As result of capitalizing expenses, lower expenditure and subsequently higher profits were reported. Investors were misled by the false regular operating performance, while profits were overstated.

The Demise of Arthur Andersen

Arthur Anderson was a large and reputable accounting firm, and was part of the then Big Five [3] . Interestingly, Arthur Andersen was the auditor for both Enron [4] and WorldCom. It was the auditor of Enron for sixteen years, since 1985 when Enron was formed. In addition to the fact that Enron had become one of the largest clients of Arthur Andersen over time, it performed both external audit and provided internal audit services as well. In return Enron paid Arthur Anderson huge sums, involving tens of millions of dollars. By virtue of being the auditors, it was Arthur Andersen's responsibility to ensure the accuracy, reliability and the overall credibility of Enron's financial statements to enable users to make sound financial decisions based on the audited financial statements.

The corporate scandals tarnished the reputation of the audit profession as a whole. Arthur Anderson blindly and systematically endorsed the accounts handed over by Enron's management. This unethical behaviour raised serious questions to the audit profession, considering 'the extent of the fraud, as well as Anderson's prestigious reputation' (Aglietta & Reberioux, 2005). Conflicts of interests in firms were a contributing factor. This is a frequent problem in the audit profession. These conflicts arose when auditing firms started providing consultancy services beyond auditing to their client. Not wanting to lose the profitable consultancy services (which undoubtedly brought in huge sums of income), audit firms indulged in such activities such as lowballing of audit fees and were inclined to be more tolerant towards the accounts presented. The sole reason for this was that they could not risk losing a profitable client as a result of disapproving its accounting practices. Independent appointment of the company's auditors by the company's shareholders is frequently replaced by subjective appointment by company bosses, where the auditor is all too often beholden to the company's senior management (Solomon & Solomon, 2004). Dividing between the auditing and consultancy arms of auditing firms, or prohibiting auditing firms to offer both services to the same client may help solve the conflict of interest problem. Rotation of auditors so as to avoid developing special relationships may be another solution.

A similar reasoning is attributable to Arthur Anderson for not detecting the accounting fraud and manipulation at Enron and WorldCom. It gave in to the demands of Enron's management for fear of losing the lucrative consultancy income in addition to the much lesser audit fees. Clikeman (2009) also shares a similar view. He points out that since WorldCom was an important client for Arthur Andersen, perhaps it was not in their best interest to discover the fraud. Of the 64 million dollars that WorldCom paid to Arthur Andersen annually, only 14 million was for their auditing services. The remaining 50 million was for other services like consulting and support.

As pointed out in CPA, 2009, Anderson was a 'client pleaser'. Arthur Andersen had compromised its auditor independence as a result of the provision of the non-audit services. Buondonno, et. al., (2005) is quite correct in stating that the so called "independent audit" by Arthur Andersen was independent in name only, and not in actual fact.

The fallout with Enron was not the first time Arthur Andersen made news headlines due to irregularities in accounting practices [5] . Time and again the firm had apparently settled a number of cases relating to allegations that auditors concealed or failed to reveal material misstatements within financial reports. Many settlements involving millions of dollars preceded the Enron scandal, which at that time was the largest bankruptcy case in the history of United States. It was one of America's major inquiries into a firm's illegal accounting practices and trying to conceal it from the shareholders and credit lenders.

As a response to these corporate scandals, the United States government promulgated the Sarbanes-Oxley Act [6] to restore confidence in the US security markets.

Sarbanes Oxley Act 2002

SOX was signed into law on July 30th 2002 by George Bush (The Economist, 2007). SOX relates to all company's listed on US markets, irrespective of their nationality. Notably, the Public Company Accounting Oversight Board (PACOB), a body responsible for audit supervision, was established. Prior to the adoption of SOX, the accounting profession was largely self regulating. With respect to auditor independence, the body is quite uniquely independent from the audit profession, as it is composed of a minority of audit professionals (only two out of five members), thus aiming to prevent potential conflicts of interest. As a result of SOX, audit committees are given a greater role, while maintaining director independence. The Securities and Exchange Commission (SEC) is authorized to strike a company off the exchange if its audit committee, directly responsible for appointing, paying and supervising the external auditor, is not entirely composed of independent members (Aglietta & Reberioux, 2005).

It addresses the perceived weaknesses in auditing, reporting and corporate governance of public companies in the United States. It set new reporting requirements and strengthened regulations for public corporate governance. The Sarbanes Oxley Act tries to address the weaknesses in four different areas:

Define the suitable relationship between independent auditors and the company being audited

Specifying appropriate corporate governance practices and inappropriate corporate governance activities

Decide the right regulation with respect to corporate fraud and accountability

Establishing requirements that companies implement and document internal control systems to help ensure the integrity of financial information being reported to the public (Stephens & Schwartz, 2006).

The first two sections of SOX (Title I: Public Company Accounting Oversight Board, and Title II: Auditor Independence) deal with the auditors of publicly traded companies and relationships between a company and its auditors. This section tries to overcome the independence problem prevalent in the accounting scandals. There are limitations on the amount of consulting services that auditors may perform for clients. This particularly concerns companies preparing for an initial public offering (IPO). In addition, the non-audit services are required to be approved by the companies audit committee. SOX further requires that the CEO, controller, CFO, chief accounting officer, or any person in an equivalent position must not have been employed by the auditing firm during the 12 months preceding the audit. Companies considering an IPO must be in compliance with these provisions at least 36 months prior to the IPO.

The third section of SOX (Title III: Corporate Responsibility) requires companies to have an audit committee, with a further requirement that each member of the audit committee to be an independent member of the board of directors. Making the audit committee independent and giving it, not the boss, the responsibility for hiring the auditor, was also a big step forward, which may have contributed to the improved performance of auditors (The Economist, 2007). Public companies are required to have audit committees which will be responsible for the audit and the selection of auditors. Companies must also disclose whether at least one member of the audit committee is a financial expert. Henceforth, it is mandatory for auditors to report to the audit committees and not the management. Other aspects aimed at improving corporate governance include the requirement for the CEO and CFO to certify the financial statements, require that a corporate code of ethics be put in place for top management, increased amount of disclosures regarding transactions involving the company and principal stakeholders, directors, or officers to be made and prohibition of the purchase or sale of stock by officers, directors and other insiders during blackout periods.

Further on, SOX also deals with corporate fraud and accountability. Title VIII imposes criminal penalties for destroying, altering, concealing or falsifying records where the intent is to obstruct a federal investigation or a bankruptcy proceeding. The statute of limitations for private actions for securities fraud is extended to not later than two years after discovery of the fraud or five years after the violation occurred. Hence, companies need to develop, implement, and periodically review document retention and destruction policies.

Enhanced whistleblower protection is another characteristic of SOX, which ensures an avenue for employees for 'confidential, anonymous submissions' of fraud evidences and that there is no discrimination against whistleblowers. SOX specifically requires that audit committees establish procedures for whistleblowers' complaints. Personal loans to directors and executive officers are also prohibited. While SOX accomplishes to limit the benefits of negligent or satisfactory audit practices, the penalties for such behaviour are not that harsh.

SOX imposes heavy compliance costs on publicly listed entities. Parles, et. al., (2007) suggests that the costs of compliance may include several factors, such as auditing expense increases, legal fees, staff increases, and technology upgrade costs. Since SOX is mandatory only for the listed US public companies, several firms have gone private or deregistered their securities, so as to avoid complying with SOX and its related costs. Companies have also elected to delay their IPO's as a consequence. According to a study conducted by the law firm of Foley & Lardner in 2003 and 2004, of the 115 public company respondents to Foley & Lardner's survey, 21% indicated that they were considering going private, 6% indicated they were considering selling the company, and 7% indicated they were considering merging with another company as a result of SOX requirements (Stephens & Schwartz, 2006). Hence compliance with SOX has made it more expensive to be a public company. It may have the effect of deterring smaller companies from going public or some public companies electing to withdraw from the public markets.

However, there are perceived benefits of SOX as well. Stakeholders may view SOX compliance as a best practice that a company should follow. A large collection of best practices have already arisen from the implementation of SOX. One of the most important best practices to come out of SOX documentation is the performance of a risk assessment (Jeffrey & Lourens, 2008). Raising funds for non SOX compliant firms is particularly difficult and expensive, as is the case with private companies. Generally, complying with SOX will ensure that firms will avoid at least some of the fraudulent accounting practices which led to the corporate collapses. Particularly for the benefit of investors, SOX has provided better risk management, reduced fraud risk, improved corporate governance and enhanced control.

The lack of auditor independence is viewed as a major contributor to the corporate collapses mentioned earlier. SOX overcomes this problem by forbidding the provision of most non-audit consulting services by the auditors of public firms to their audit clients. Though the accounting firms are permitted to provide taxation services to their audit clients, they can only do so with prior approval from the audit committee.

SOX gives further priority to auditor independence, with the rotation of audit partners in charge of audit clients. Lead audit partners and audit partners who are responsible for review of the audit must be rotated off after five years. These partners are further subject to a five-year time-out period. Other audit partners, excluding lead or concurring partners, are subject to a seven-year rotation and a two-year time-out period. SOX also mandates a one-year "cooling off" period for auditors from going to work for an audit client in a key position.

SOX is slowly but surely becoming a set of extremely strong best practices, and something like SOX will likely become the standard, if not the requirement for all companies in the near future (Jeffrey & Lourens, 2008).

Will SOX remedy any deficiencies in the financial regulations and avoid future collapses?

The adoption of SOX has improved corporate governance practices of companies. Even the directors of private companies, who are not governed by SOX, are feeling its good governance influence (Hoffman, 2003). SOX compliance can reduce the opportunities for committing fraud, but it does not entirely such opportunities. As per the fraud triangle, the motivations for fraud are pressure, opportunity and rationalization. Therefore, although SOX can limit the opportunity for fraud, there will still be avenues open through pressure and rationalization.

While there has not been any corporate fraud as drastic as Enron and WorldCom, it cannot be denied the there are ongoing fraud committed in the finance sector. Ponzi schemes are a very good example. SOX is just another legislation. It has been proved with the ponzi schemes that legislation alone cannot stop fraud. Fuller (2009) suggests that ethics and honesty is the way to go. Honesty should take priority over profits. "If you only emphasize profits and performance, eventually fraud will rear its ugly head and the entire company could be at stake. If you emphasize ethics and honesty, the profits may not be as substantial but at least you know them to be true" (Fuller, 2009). A similar view is shared by Eichar (2009), who suggests that legislation and regulation cannot eliminate fraud completely.

The issue of auditor independence and conflict of interest is also addressed in SOX through mandating external auditors to limit their services to each client to external auditing or other services, but not both. However, though this seems to be a perfect measure, it will definitely not work where auditors and their client, or certain employees collude. It is possible that people can collude and not declare their interests, and therefore compromising auditor independence. Siiro (2009) states that SOX will do nothing to prevent collusion between individuals within an organization, which bypass internal controls and is immeasurably more difficult to prevent from occurring.

SOX requires CEO's and CFO's to sign on financial statements sent to SEC, and holds them accountable for any deficiencies. Heavy jail terms are mandated for signing falsified statements. This requirement is not sufficient to prevent another corporate collapse. CEO's and CFO's can always argue that they did sign on the financial statements, but they did not know of any material misstatements. Again, collusion will beat this clause of SOX.

The internal controls over financial reporting in place at Enron and WorldCom were excellent (Hurley, 2005). The reality was that appropriate internal controls were in place, but the top management overruled the controls. "Internal controls over financial reporting will only function well in preventing financial statement fraud when they are allowed to, because the perpetrators are usually in a position to command their underlings to ignore such controls" (Hurley, 2005). As a response to the weak internal control issue, SOX requires public companies to review their internal controls annually and auditors are further required to certify managements review of the internal controls over financial reporting. As earlier mentioned, collusion and top management might defeat the purpose of this requirement of SOX.

SOX's requirement for a code of ethics, on a positive note, is designed to minimize unethical accounting practices and possibly boost investor confidence. However, with a deeper insight into a code of ethics, it is just a set of written guidelines to follow. A code of ethics would not have prevented the Enron or WorldCom collapse. It is simply useless if it does not have proper enforcement and compliance mechanisms. As such, the requirement of SOX for companies to have a code of ethics alone will not avoid fraud and scandals.

The rotation of auditors every five years to prevent conflicts of interest also does not seem sufficient. There is room for collusion and special relationships can certainly be developed within 5 years.

The auditing profession can generally be said to be rather ineffective in detecting financial statement fraud. This view is consistent with Jamal (2006), who states that "there are almost no cases documented of major frauds brought to light by the external auditor". Risk based auditing is one of the factors making auditing ineffective in detecting fraud. Inaccuracies in measuring risk may lead to potentially highly risky elements of the financial statement go unaudited. The ineffectiveness of the audit profession is also prevalent when normal stock market weakens, particularly during bubble periods. This was clearly depicted by the recent US financial crisis, where the audit profession failed to detect the asset bubble in a timely manner. As Jamal (2006) argues, audit has failed as a strategy to detect fraud.


Enron and WorldCom scandals were one of the largest corporate collapses in the history of America. Having high profits and growth rates through fraudulent accounting practices and manipulation, these firms were able to hide their actual economic reality from their shareholders and particularly their auditors, Arthur Andersen. The auditors failed to detect the deficiencies in the accounting system. Some of the reasons attributed to this are to avoid losing the big clients and large amounts of income from non-audit services. Conflict of interest and auditor independence was highly compromised, apart from the activities being unethical. As a direct result of these corporate collapses, the SOX was legislated by the US government. SOX was designed to restore the investor confidence in the US economy after the high profile collapses, and presumably avoid any such scandals in future.

The effectiveness of SOX as a tool to avoid corporate collapses and fraudulent activities has been highly debated. However, it is worth noting that SOX is only legislation. It does minimize the opportunities for fraud, but does not completely eradicate it, as has been evidenced by the corporate fraud after the implementation SOX. Hence it is pertinent to conclude that while SOX can minimize the chances of another Enron or WorldCom, SOX does not guarantee that there won't be future failures in the corporate world.

The audit profession also seems to have failed in the area of detecting fraudulent accounting practices, at least to a major extent.